Risk Assessment & Asset Allocation Flashcards

In the context of alternative investments, which risk is most unique to private equity compared to public equities?

Answer: Illiquidity risk due to lock-up periods and limited secondary market access

Private equity investments typically have multi-year lock-up periods with no liquid secondary market, creating illiquidity risk that is fundamentally different from publicly traded equities.

An asset allocation model shows a portfolio has a maximum drawdown of -35%. This metric represents:

Answer: The peak-to-trough decline in portfolio value over a specified period

Maximum drawdown measures the largest peak-to-trough decline experienced, giving investors insight into the worst historical loss they would have endured.

Which scenario best illustrates concentration risk in a portfolio?

Answer: Holding 30% of the portfolio in a single technology stock

Concentration risk arises when a disproportionately large allocation to a single position or sector exposes the portfolio to idiosyncratic events that affect that holding.

The Capital Market Line (CML) in modern portfolio theory connects the risk-free rate to:

Answer: The tangency portfolio, which has the highest Sharpe ratio

The CML runs from the risk-free rate through the tangency portfolio (optimal risky portfolio), representing all efficient portfolios combining the risk-free asset and the market portfolio.

In stress testing a fund's asset allocation, a manager should primarily focus on:

Answer: Portfolio behavior under extreme adverse scenarios, including correlations rising toward 1

Stress testing examines how a portfolio performs under severe conditions, particularly noting that diversification benefits erode when inter-asset correlations spike during crises.

A fund manager shifts from a 50/50 stock/bond allocation to 70/30 based on a short-term macroeconomic outlook. This is an example of:

Answer: Tactical asset allocation

Tactical asset allocation involves temporary deviations from the long-term strategic allocation to exploit shorter-term market opportunities or manage near-term risks.

Which of the following best describes the risk-return tradeoff of adding emerging market equities to a developed-market portfolio?

Answer: Higher expected returns with higher volatility, but potential diversification benefits from lower correlation

Emerging markets offer higher growth potential and expected returns but come with higher volatility, political risk, and currency risk, with partial diversification benefits when correlations are below 1.